“It’s often the small things that no one sees that result in the big things that everyone wants” – Craig Groeschel
I have invested in over 100+ companies over my microcap investment career. A great majority of these microcap companies were founder led. The smaller the company the more important the founder, CEO, and management become to a company. The founders of small companies wear a lot of different hats. They aren’t just the CEO, but they are often the VP of Sales, Marketing, Human Resources, and many things in between.
Evaluating founders is a big part of what I do as a full-time microcap investor because my success hinges on their ability to execute. I’ve been asked a few times about how I evaluate founders and what key attributes I look for. Over the years I’ve formed my own mental framework based on my experiences. What I’ve found is it’s often the small, intangible, qualitative attributes or characteristics that have made the greatest impact on my future returns. I’m going to highlight a few of these “Small Things that Make a Big Difference” in a series of blog posts over the next few months.
To explain the first attribute, I need to first give a brief history of how small US microcap companies have historically gone public. Up until 2010-2011, a majority of the small microcap companies (sub $50 million market cap) went public through the reverse merger process (aka RTO or Reverse Takeover) versus a traditional IPO. This form of going public is widely accepted in almost every geographic stock market place (Canada, Australia, etc). A reverse merger is when a private company merges with a public shell company (shell = a trading symbol and entity without a business). A shell company is sort of like a commercial office building with no tenants. They are just waiting for a business to move in. Small investment banks, advisory groups, and consultants were the facilitators of lining up private companies with shell companies, and providing funding. This was a simpler, cheaper, and easier way for companies to raise a smaller amount of capital ($1-5 million) and go public.
In the mid-2000’s, there were 400-600 reverse mergers per year in the United States, so there was an ample supply of new microcaps going public on US exchanges. Around the 2010 timeframe several China fraud cases were brought to light. These companies also used the reverse merger process to go public. The financial media and regulators immediately attacked reverse merger companies shining a negative light on this form of “going public”. The negative sentiment surrounding reverse mergers drastically reduced the amount of small microcap companies going public. [My analogy] To kill a couple alligators in the lake, they killed everything in the lake. Since 2010, there have been around 100 reverse mergers per year on US markets.
Many microcap companies that go public via reverse mergers are unprofitable and undercapitalized. This isn’t dissimilar to what you would expect in a small emerging company market place (venture capital, etc). Many of the service providers that facilitated the reverse mergers quickly went onto the next deal. The founders of these newly public microcap companies often had very low public company IQs. They had very limited capital markets experience. They were thrown into the deep end of a pool without knowing how to swim. Some ended up drowning.
Failure can take many forms. One form is a business fails because it was a bad business. Another form, is a business fails because they just run out of time and money. In yet another case, it’s the founder’s lack of public company IQ that destroys any hope for long-term value creation. Running a small public company is quite different than running a small private company. In the latter case, the business may have succeeded but they took advice from the wrong people and took money from the wrong people. In the end, they completely blew up the capital structure (ie too many shares out and/or preferred convertible high interest debt, structured financings, etc), and the result was an un-investable company.
Small Thing #1: Managed through adversity without diluting common shareholders
When I look back at a majority of my winners, most of them went public through the reverse merger process. These founders too were thrown into the deep end of the pool without knowing how to swim. But these exceptional entrepreneurs were the outliers that somehow figured out how to swim. These people were the business equivalent to this Rocky Balboa quote, “Life is about how hard you can get hit and keep moving forward”. They grinded and bootstrapped their companies and focused on profitability. And most importantly, they turned things around without significantly diluting common shareholders or blowing up their capital structure.
Coincidentally, these successful microcap founders often have iconoclastic traits similar to what William Thorndike describes in, The Outsiders, and on point with what Sean Iddings and I discovered while writing the Intelligent Fanatics Project. They are highly driven individuals with long memories. They remember the pain and feel like they were left for dead by the service providers that took them public. This inner anger is why they never cater to Wall Street. However, they are highly loyal to their long-term investors.
Many investors turn away from companies that went through adversity because it shows management didn’t get it right from the beginning. I actually prefer to see adversity because it lets me see who they really are. When a founder and management team did right by common shareholders in the worst of times, it is much easier to trust them in the best of times.
This is one of several small things I look for in founders that have made a big difference in my returns. I will highlight a few more in subsequent articles.
If you liked this post, you will also enjoy:
MicroCapClub is an exclusive forum for experienced microcap investors focused on microcap companies (sub $300m market cap) trading on United States, Canadian, UK, and Australian markets. MicroCapClub was created to be a platform for experienced microcap investors to share and discuss stock ideas. Investors can join our community by applying to become a member or subscribing to gain instant view only access. MicroCapClub’s mission is to foster the highest quality microcap investor Community, produce Educational content for investors, and promote better Leadership in the microcap arena. If you enjoy the search for the next great company, Join Us.